Investment Strategies

Question 1

Dollar Cost Averaging

Answer 1

Dollar cost averaging is the practice of purchasing a fixed dollar amount of stock or stock funds at specified intervals. The logic behind dollar cost averaging is that by investing the same dollar amount each period instead of buying in one lump sum, you’ll be averaging out price fluctuations by buying more shares of common stock when the price is lower, and fewer shares when the price is higher.

Dollar cost averaging is a natural component of a savings plan of someone who invests a certain amount every month for a specific period of his or her life. What would you do if someone has a large lump sum (from a monetary settlement, retirement distribution, rollover of retirement assets, inheritance, or monetary windfall) to invest and is afraid of getting into the downward trending market? One way to hedge against buying into a tumultuous market is to dollar cost average by putting the lump sum into an interest-paying cash equivalent such as a money market mutual fund and investing small portions of it into a stock or stock fund regularly until the whole amount is invested. A client could do this by moving all of the lump sum into a money fund and establishing a systematic exchange where a smaller sum is exchanged for a stock fund on a regular basis.

Question 2

Dividend Reinvesting

Answer 2

If you want to use common stock to accumulate wealth, you must reinvest rather than spend your dividends.

Under a dividend reinvestment plan (DRIP), you are allowed to reinvest the dividend in the company’s stock automatically without paying any brokerage fees. Most large companies offer such plans, and many stockholders take advantage of them.

However, DRIPs have their own drawbacks.

When you sell your stock, you’ll have to figure your cost basis for your dividends that are reinvested. In addition, you will pay income tax on the reinvested amounts as if you actually received these dividends.

You can’t choose what to do with your own dividend. For example, if the company you’ve invested in is performing moderately well, and you just heard about another company whose stock price is rising faster. You are stuck reinvesting instead of trying something new.

Question 3

Bond Ladders, Bullets and Barbells

Answer 3

Similar to dollar cost averaging, strategies around bond maturities give investors who are unsure about the future market conditions a strategy to hedge their risk and receive some return with certainty. To provide a certain average duration, bond portfolio managers will utilize different maturity structures called ladders, barbells, and bullets. They choose between these options based on their expectations of the direction of the yield curve. Those investors who anticipate the yield curve to become steeper will use a bullet strategy. Those who expect the yield curve to flatten will pick the barbell. Those who are neutral or uncertain will buy a ladder.

Question 4

Bond Ladder

Answer 4

A ladder structure is a portfolio of bonds that mature at regular intervals throughout the various maturities of the yield curve. To perpetuate a ladder structure, as each bond matures, the proceeds are used to purchase a bond that will mature at the next interval after the one with the longest maturity in the portfolio. Ladders are most effective when the yield is normal or sloping upward and interest rates are fairly stable. Ladders are typically constructed using U.S. Treasuries or even CDs at a local bank.

If an investor believes the yield curve is going to steepen, a ladder makes more sense than a barbell. Since bonds are coming due at regular intervals, an investor is never at risk of having an entire portfolio come due in a lower interest rate environment and there will always be some money to invest when rates are higher. However, by spreading purchases out along the entire yield curve, an investor loses his or her opportunity to outperform the market.

Question 5

Bond Barbell

Answer 5

A barbell is a strategy of holding more bonds at the short and long end of the yield curve with intermediate bonds being underweighted. This allows a portfolio’s price to match the volatility of an intermediate-term liability. When there is a likelihood that the Federal Reserve will loosen monetary policy in the near term, a barbelled portfolio may increase a bond portfolio’s return.

As with all investing, have a diversified bond portfolio of high-yield, municipal, and corporate bonds. They have two advantages that can be utilized in a barbelled portfolio. First, high-yield and corporate bonds help diversify a portfolio versus a treasury only portfolio. Their performance is also largely isolated from what’s happening with government interest rates because their yields depend almost entirely on default risk. Second, compared to equity alternatives, they are often undervalued. If the yield curve continues to flatten, the return on a barbelled portfolio is optimized.

Question 6

Bond Bullet

Answer 6

A bullet-structured portfolio benefits when the yield curve is expected to steepen. A bullet structure usually weighs heavier around intermediate term assets. A bulleted maturity tends to outperform a barbell structure when the yield curve steepens because in a rising rate environment, intermediate-term securities usually hold up better than long-term securities. Also, in a declining interest-rate environment, intermediate securities produce significantly greater price appreciation than do short-term securities.

Question 7

Market Cycles

Answer 7

Developed economies around the world are known to experience market cycles. Market Cycles are the natural expansion and contraction of the economy over time around a trend line. In general, this cycle is upward trending over longer periods of time which illustrates the long-term growth of the economy. However, through this long term growth trend there will be off-and-on periods of growth and periods of recession (or contraction)

The way to think of this process outside the economy is to consider the life cycle of a tree. While the tree grows larger over time, it goes through periods of extreme growth in the spring, leveling out in the summer and then shedding it leaves in the fall into a dormant state for winter.

The four key phases of the Market Cycle are:

Expansion
Peak
Recession/Contraction
Trough

Question 8

Expansion Market Cycle

Answer 8

During the expansion phase there is typically a skeptical optimism as the economy begins to recover and grow out of the previous recession. Often the Government has intervened and supplied the economy with capital in the form of stimulus or low interest rates (or both in recent times). This capital sparks the beginning of new growth and innovation.

The following economic characteristics define the phase:

Gross Domestic Product (GDP): Increasing (above trend)
Interest Rates: Low / Accommodating Policy
Credit Access/ Availability: Growing and more easily Available
Credit Spreads: Tight
Employment: Increasing
Sales: Growing
Corporate Earnings: Increasing
Inventories: Low
Inflation: Increasing

Tactical Positioning Favors: Stocks and Commodities

Question 9

Peak Market Cycle

Answer 9

Cycle Peaks tend to be the most challenging to predict. Most investors believe they will continue to see profits and unlimited upside based on the recent expansion. This creates the “greed effect” or a “can’t lose” attitude. This is referred to a “euphoric period” in the stock market when there are very few investors concerned about a decline.

The following economic characteristics define the phase:

Gross Domestic Product (GDP): Peaking/ Slowing growth rate
Interest Rates: Increasing
Credit Access/ Availability: Growing availability
Credit Spreads: Tight
Employment: Slowing Growth
Sales: Increasing
Corporate Earnings: Peaking / Slowing growth rate
Inventories: Growing
Inflation: Moderate

Tactical Positioning Favors: Bonds, Low Beta Stocks

Question 10

Recession Market Cycle

Answer 10

As the economy moves to recession, the inevitable sets in, and investors tend to sell their high performing positions. This mass sale tends to create significant volatility in the markets as investors move to reposition their portfolios to more conservative and less volatile positions. Equity markets tend to decline broadly at this point.

The following economic characteristics define the phase:

Gross Domestic Product (GDP): Declining (below trend)
Interest Rates: Higher
Credit Access/ Availability: Tightening
Credit Spreads: Widening
Employment: Declining (unemployment increasing)
Sales: Declining
Corporate Earnings: Declining
Inventories: Growing
Inflation: Declining or Deflating

Tactical Positioning Favors: Bonds

Question 11

Trough Market Cycle

Answer 11

Eventually, the economy and the markets hit a point where they cannot reasonably go much lower. Value and contrarian investors step in and begin to buy again. In addition, in more recent history, this is the point when the government has stepped in and provided liquidity and support to individual companies, industries, and the market as a system. This was done to avoid systematic crisis. This Government intervention is somewhat controversial, but it has helped to slow and reverse the recession moving the economy back towards expansion once again. It should not be counted on, but as investment planners, we must be aware of its more recent impact.

The following economic characteristics define the phase:

Gross Domestic Product (GDP): Stable
Interest Rates: Declining (Policy easing)
Credit Access/ Availability: Tight
Credit Spreads: Wide
Employment: Weak
Sales: Down
Corporate Earnings: Declining
Inventories: Declining
Inflation: Stable to increasing

Tactical Positioning Favors: High Beta Stocks

Question 12

Investment Strategies

Answer 12

Investment professionals adopt a variety of strategies in order to either stimulate their target benchmark index’s return or to beat it. There is some merit to each of the strategies, and some strategies work better in specific market environments. Overall, it is important to determine whether or not the strategy suits your client’s risk tolerance, time horizon and of course, investment objectives. This lesson helps you identify the purpose of each investment strategy and the type of investor who can take advantage of it.

Investment strategies::

Market Timing
Passive Investing (Indexing)
Buy and Hold
Technical Analysis
Efficient Market Anomalies
Fundamental Analysis
Portfolio Immunization
Active Bond Portfolio Management

Question 13

Market Timing

Answer 13

“Buy low, sell high.” This sentiment is the epitome of market timing. The strategy is simply trying to buy securities when the market is down and sell them when the market is high. The hard part is predicting when the market is at a low and when it is at a high. Unfortunately, novice investors tend to let emotions get in the way of investing and do the reverse. They tend to sell when the investment is losing its value and buy when the investment has done well for some time.

A market-timer structures a portfolio to have a relatively high beta when he expects the market to rise and a relatively low beta when a market drop is anticipated. In other words, a market timer will:

hold a high-beta portfolio when Expected Market Return > Risk-free Return, and
hold a low-beta portfolio when Expected Market Return < Risk-free Return.
If the timer is accurate in his forecast of the expected return on the market, then his portfolio will outperform a benchmark portfolio that has a constant beta equal to the average beta of the timer’s portfolio. However, forecasting the market return is the hard part. The actual result will be determined by the accuracy of his or her forecast regarding the relationship between the market’s return versus a risk-free return.

To “time the market,” one must change either the average beta of the risky securities held in the portfolio or the relative amounts invested in the risk-free assets and risky securities. For example, selling bonds or low-beta stocks and using the proceeds to purchase high-beta stocks could increase the beta of a portfolio. Alternatively, Treasury bills in the portfolio could be sold, with proceeds being invested in stocks or stock index futures. Because of the relative ease of buying and selling derivative instruments such as stock index futures, most investment organizations specializing in market timing prefer the latter approach.

Market timing comes with relatively high risk. As the last few market cycles have shown, the predictability of market moves can be hard, and more importantly, the movements can occur quickly, making it hard to time or reposition. For example, if you move to lower beta stocks and the market goes up quickly your performance will lag, and you must then decide to hold your position or increase beta (risk) after the market has run up. This second scenario is often more difficult to stomach and decide.

Most practitioners do not have a strong broad-based conviction on market timing, though some investment managers have successful track records with tactical portfolios.

Question 14

Passive Management (Indexing)

Answer 14

Within the investment industry, a distinction is often made between passive management—holding securities for relatively long periods with small and infrequent changes—and active management.

Passive managers generally act as if the security markets are relatively efficient. Put somewhat differently, their decisions are consistent with the acceptance of consensus estimates of risk and return. The portfolios they hold may be surrogates for the market portfolio, known as index funds, or they may be portfolios that are tailored to suit clients with preferences and circumstances that differ from those of the average investor. In either case, passive portfolio managers do not try to outperform their designated benchmarks.

Active managers believe that from time to time there are mispriced securities or groups of securities. They do not act as if they believe that security markets are efficient. Put somewhat differently, they use deviant predictions; that is, their forecasts of risks and expected returns differ from consensus opinions.

For example, a passive manager might only have to choose the appropriate mixture of Treasury bills and an index fund that is a surrogate for the market portfolio. The optimal mixture is only changed when:

the client’s preference changes
the risk-free rate changes, or
the consensus forecast about the risk and return of the benchmark portfolio changes.
The manager must continue to monitor the last two variables and keep in touch with the client concerning the first one. No additional activity is required.

Question 15

Buy and Hold

Answer 15

A buy-and-hold investment strategy involves buying stock and holding it for a period of years. There are four reasons why such a strategy is worth considering.

The following is a list of reasons when considering the buy-and-hold strategy:

It aims at avoiding market timing. By buying and holding the stock, the ups and downs that occur over shorter periods become irrelevant.
It minimizes brokerage fees and other transaction costs. Constant buying and selling really racks up the charges, but buying and holding has only the initial purchase charge. By keeping these costs down, the investor retains more of the stock’s returns.
It helps postpone any capital gains taxes when you are holding and not selling the stock. The longer you can go without paying taxes, the longer you hold your money, and the longer you have to reinvest and earn returns on your returns.
It helps your gains to be taxed as long-term capital gains.

Question 16

Technical Analysis

Answer 16

One of the major divisions in the ranks of financial analysts is between those using fundamental analysis and those using technical analysis.

Technical analysis is the study of the internal stock exchange information. The word technical implies a study of the market itself, the “push” and “pull” of supply and demand forces on the market. Technical analysts track market statistics such as price levels and the trade volume in the exchanges.

The technician usually attempts to predict short-term price movements and thus makes recommendations concerning the timing of purchases and sales of either specific stocks, groups of stocks (such as industries), or stocks in general. The methodology of technical analysis rests upon the assumption that history tends to repeat itself in the stock exchange.

Thus, technicians assert that the study of past patterns of variables such as prices and volumes will allow the investor to accurately identify times when certain specific stocks (or groups of stocks, or the market in general) are either overpriced or under-priced. Most, but not all, technical analysts rely on charts of stock prices and trading volumes.

It is very useful to understand that the technician would argue these stock movements and information gained from charts exist because of the other investors in the security. These patterns do not exist for no reason, the patterns represent investor behavior that can become repeating or may be predictable to a certain degree.

Technical analysis uses the following methodologies to determine profitable stock selection and market timing opportunities:

Charting Strategies involve the examination of historical price patterns, moving average and trading breakout techniques.
Sentiment Indicators include contrarian statistics and one of the most accurate of all technical indicators, the Barron’s Confidence Index.
Flow of Funds Indicators examine the amount of funds that are available to invest.
Market Structure Indicators involve looking at the desirability of the overall market and opportunistic entry points.

Question 17

Efficient Market Anomalies

Answer 17

Efficient markets are those markets for securities in which every security’s price equals its investment value at all times, implying that a specified set of information is fully and immediately reflected in market prices.

To test for market efficiency is to investigate whether there are any patterns in security price movements attributable to something other than what one would expect. In recent years, a large number of these patterns have been identified and labeled as empirical regularities or market anomalies.

The desire of individuals for liquidity may be thought to change from day to day and from month to month. If it does, there may be seasonal patterns in stock returns. You might presume that such patterns would be relatively unimportant. Indeed, there is evidence indicating that such market anomalies are present and could be exploited to earn abnormal returns. The following are some examples:

The January Effect - A study that looked at the average monthly returns on NYSE-listed common stocks, found significant seasonalities. In particular, the average return in January was higher than the average return in any other month.
The Day-of-the-Week Effect - Studies that looked at the average daily return on NYSE-listed securities found that the return on Monday was quite different from returns on other days. In particular, the average return on Monday was found to be much lower than the average return on any other day of the week.
Small Firm Effect - An investor buys firms which have the ability to generate supernormal growth from quarter to quarter.
Neglected Firm Effect - Stocks that are not followed by any (or very few) analysts have been shown to generate superior performance.
Low P/E Effect - Stocks that have low price to earnings ratios (the so-called value stocks) outperform all other types of stocks (including growth stocks) over the business cycle.
Value Line Phenomenon - The Value Line Investment Survey is stock research that is available through subscriptions. The service ranks 1,700 widely held securities according to their projected performance over a 6-12 month period. Since the mid 1960s, the Value Line portfolio of stocks ranked 1 have outperformed the S&P 500 Index 17 fold! This statistic does not include taxes and transaction costs.

Question 18

Sector Rotation

Answer 18

Sector rotation is an active - tactical investment strategy that seeks to take advantage of the outperformance and underperformance that occurs in specific areas of the market during market cycle phases. Recall, the four market cycles are; expansion, peak, recession, and trough. The perceived advantage of this strategy is that timing the market cycle and reallocating capital into sectors that will outperform (from sectors that will underperform) will lead to performance that is better than indexing or buy and hold alone.

The challenge with sector rotation strategies is that timing a market cycle on a predictive basis is rather difficult to do. In addition, if a majority of the market place is attempting to follow this strategy the outperformance of these sectors will begin to fade in time.

This strategy can be implemented in two distinct ways: As a pure sectors rotation strategy, which will move money fully in and out of sectors completely. The other option is to own in some amount all of the sectors, but overweight and underweight the sectors expected to outperform or underperform.

Question 19

Core-Satellite

Answer 19

The use of a core-satellite strategy can take many forms and it tends to be a fairly popular strategy regardless of whether the formal name is used. The main focus of core-satellite structure is that there should be a core portfolio and a satellite portfolio. Note, these can exist within the same actual investment account.

In general, a core is either a “buy and hold” or an indexed investment strategy that is rarely modified. This portion of the strategy tends to follow a strategic long term investment philosophy. Around the core is a portfolio or collection of several portfolios that are considered satellites. These satellite portfolios can range in investment strategy to include any number of other investment styles or strategies. For example, a satellite may consist of a tactical sector rotation portfolio, or it may include hedge funds and private equity investments (or all of the above). There is no real limitation with how many satellite portfolios a client may have.

Conceptually, the core portfolio serves to create a more predictable/traditional long term investment return stream while also lowering total portfolio cost, taxes, and risk. The satellites seek to provide alpha, or outperformance, by taking on more risk or investing in more niche market areas.

Question 20

Environmental, Social, and Corporate Governance (ESG) Investing

Answer 20

Environmental, Social, and Corporate Governance (ESG) is not a new concept, but it has grown in popularity and grown in mainstream investment practice. There is greater acceptance that investment returns with social benefits can be just as good as, or better than, investments that do not focus on ESG factors. This is largely the reason behind broader adoption and acceptance initially. Overall, ESG focused investment strategy is designed to invest in companies that have a positive impact in a number of ways. In addition, this practice of investing tends to avoid companies that are perceived to have a negative impact.

A basic example of this practice would be to invest in renewable energy while avoiding, or divesting, from non-renewable energy holdings such as fossil fuels. This is just one example of a practice that can be implemented in many different sectors and with different ethical goals.

The key to understanding this practice is that the potential pool of investment choices is screened from the beginning for one or more criteria based on client or advisor values. The screen may be positive or negative. A positive screen seeks to invest in companies that have strong ESG factors, while a negative screen seeks to avoid companies with negative factors.

Question 21

Environmental Investing

Answer 21

Environmental factors tend to focus on the following investments:

Climate change: Reducing or eliminating companies that have a negative impact on climate issues and investing funds into companies that take a proactive view of climate issues.

Natural Resource Impact: this approach focuses more on the impact of a companies’ production on the global and local environments—for example, pollution that may occur from water runoff, the use of non-renewable or unsustainable inputs, and the overall production of waste byproducts.

Question 22

Social Investing

Answer 22

Social investment factors consider the following:

Human rights policies: This examines how a company may treat its employees domestically and overseas from a safety, diversity, fair pay and benefits, and inclusion lens.

Customer and Supplier relationships: A focus is placed on the companies’ compliance with product safety, fair competition, and responsible marketing standards.

Giving back: This criteria looks for companies that make a proactive impact on the community. This may be through volunteerism, giving back donations from company earnings, or empowering employees to provide positive impact in their communities.

Question 23

Corporate Governance Investing

Answer 23

Corporate Governance investing and analysis is arguably the most longstanding in this ESG category. It goes without question that investing in a company of any kind should be done with an understanding of the ethical quality of its decision makers.

However, what is newer about corporate governance investing is the specific criteria that makes sound corporate governance in today’s world.

The main focus of Governance based investment screening today is:

General ethical practice: This focuses on a track record of good decisions and ethical practices within the company. In addition, we want to know what policies are in place to maintain these ethical standards and to prevent corruption.

Financial Transparency: Post Enron in the late 90’s, there has been significantly more transparency created (through legislation) and emphasis when it comes to financial accounting. However, there are still many ways to stretch the limits and norms when it comes to accounting. Emphasis should be placed on companies that provide clear and informative information to shareholders and to the public.

Oversight: In this instance, the key focus would remain on how the Board manages and directs executives to maintain value for shareholders. Ideally a Board should be independent and able to make decisions that benefit the shareholders (owners) of the company.

Diversity: It has been shown in nearly all recent research that diversity of opinion and background on the corporate level creates better performance. This lens has become a larger focal point in more recent years and will likely continue to be a focus for ESG investing moving forward.

Question 24

Fundamental Analysis

Answer 24

One of the major divisions in the ranks of financial analysts is between those using fundamental analysis and those using technical analysis. Fundamental analysis looks at the fundamentals of the business, which are best disclosed on the financial statements, the balance sheet and the income statement.

The fundamentalist tends to look forward and the technician backward. The fundamentalist is concerned with matters such as future earnings and dividends. Although many investors use technical analysis, fundamental analysis is far more prevalent. Furthermore, unlike technical analysis, fundamental analysis is an essential activity if capital markets are to be efficient.

Fundamental analysts forecast, among other things, the following:

future levels of the economy’s gross domestic product
future sales and earnings for a number of industries, and
future sales and earnings for an even larger number of firms.

For example, an estimate of next year’s earnings per share for a firm may be multiplied by a projected price-earnings ratio in order to estimate the expected price of the firm’s stock a year hence. Or an estimate of future dividends may be supplied to a dividend discount model. Both approaches allow the analyst to make a direct forecast of the stock’s expected return. In other cases the conversion is implicit. For example, stocks with projected earnings substantially exceeding consensus estimates may be placed on an “approved” list.

Question 25

Top-Down vs. Bottom-Up

Answer 25

Most investment organizations that employ financial analysts follow both a sequential top-down forecasting approach, as well as a bottom-up forecasting approach.

Top-Down: The financial analysts are first involved in making forecasts for the economy, then for industries, and finally for companies.

Bottom-Up: The financial analysts begin with estimates of the prospects for companies and then build to estimates of the prospects for industries and ultimately the economy.

For example, forecasts are made for the economy in a top-down manner. These forecasts then provide a setting within which financial analysts make bottom-up forecasts for individual companies. The sum of the individual forecasts must be consistent with the original economy-wide forecast. If it is not, the process is repeated (perhaps with additional controls) to ensure consistency.

Order of Top-down Analysis
First: Region (e.g. Europe or Pacific rim)
Second: Country (e.g. Germany or Japan)
Third: Industry (e.g. Technology or healthcare services)
Fourth: Company (e.g. IBM or Tyco)

Some level of constraints must be placed on both investment managers that follow top-down or bottom-up processes for diversified investment portfolios. A portfolio of all tech stocks because they have the best P/E ratio may or may not be appropriate. Investors should not only understand the process but also what constraints are in place to control risk and concentration.

Question 26

Probabilistic Forecasting

Answer 26

Explicit probabilistic forecasting often focuses on economy-wide forecasts. This is because uncertainty at this level is of the greatest importance in determining the risk and expected return of a well-diversified portfolio.

A few alternative economic scenarios may be forecast, along with their respective probability of occurrence. Then accompanying projections are made of the prospects for industries, companies, and stock prices.

Such exercises often require analysis, sometimes referred to as what-if analysis. These exercises provide an idea of the likely sensitivities of different stocks with respect to the economy. Risks may also be estimated by assigning probabilities to the different scenarios.

The following is a simplified example of probabilistic forecasting:

• An analyst assigns a probability of the market to head to a recession versus an expansion (for example, 20% expansion and 80% recession), and then
• forecasts an expected return of both market conditions (e.g. E(r)expansion = 20%, E(r)recession = -15%)
• multiplies the probability of each market condition with respective expected return within that environment (e.g. (20%)(20%) and (80%)(-15%)), and then
• combines the two weighted expected returns (e.g. (20%)(20%)+(80%)(-15%) = -8%)

Question 27

Econometric Models

Answer 27

An econometric model is a statistical model. This model provides a means of forecasting the levels of certain variables, known as endogenous variables. In order to make these forecasts, the model relies on assumptions that have been made in regard to the levels of certain other variables supplied by the model user, known as exogenous variables. For example, the level of new homes projected to be built next year is a derivative of the level of GDP and interest rates. Therefore, the endogenous variable of housing starts is dependent on the exogenous variables of the GDP and interest rates.

An econometric model may be extremely complex or it may be a very simple formula. In either case, it involves a blend of economics and statistics. Economics is first used to suggest the forms of relevant relationships and then statistical procedures are applied to historical data to estimate the exact nature of the relationships involved.

Some investment organizations use large-scale econometric models to translate predictions about factors such as the federal budget, expected consumer spending, and planned business investment into predictions of future levels of gross domestic product, inflation, and unemployment.

Large-scale econometric models employ many equations that describe many important relationships. Although estimates of the magnitudes of such relationships are obtained from historical data, these estimates may or may not enable the model to work well in the future. When predictions turn out to be poor, it could have been a structural change in the underlying economic relationships or from the influence of factors omitted from the model. Either situation necessitates changes in either the magnitude of the estimates or the basic form of the econometric model, or both. Econometric users usually “fine-tune” (or completely overhaul) such a model from time to time as further experience is accumulated.

Question 28

Portfolio Immunization

Answer 28

The introduction of the concept of duration led to the development of the technique of bond portfolio management known as immunization. Specifically, this technique purportedly allows a bond portfolio manager to be relatively certain of being able to meet a given promised stream of cash outflows. Thus, once the portfolio has been formed, it is “immunized” from any adverse effects associated with future changes in interest rates.

Question 29

How to Immunize

Answer 29

Immunization is accomplished by calculating the duration of the promised outflows and then investing in a portfolio of bonds that has an identical duration. In doing so, this technique takes advantage of the observation that the duration of a portfolio of bonds is equal to the weighted average of the durations of the individual bonds in the portfolio.

For example, if a portfolio has one-third of its funds invested in bonds with a duration of six years and two-thirds in bonds having a duration of three years, then the portfolio itself has a duration of four years: (1/3)(6) + (2/3)(3) = 4.

Consider a situation in which a portfolio manager has only one cash outflow to make from a portfolio: an amount equal to $1,000,000, which is to be paid in two years. Because there is only one cash outflow, its duration is two years. The bond portfolio manager can invest in two different bond issues. The first is a bond issue that has a maturity of three years. The second issue involves a set of bonds that mature in one year. The portfolio manager has the following options:

All of the portfolio’s funds could be invested in one-year bonds, with the intention of reinvesting the proceeds from the maturing bonds one year from now in another one-year issue. However, doing so would entail reinvestment risks. If interest rates were to decline over the next year, then the funds from the maturing one-year bonds would have to be reinvested at a lower rate than the one currently available.
All of the portfolio’s funds could be invested in a three-year issue. However, this choice entails interest rate risks as well. The three-year bonds will have to be sold after two years in order to come up with the $1,000,000. The risk is that interest rates will have risen before then, meaning that bond prices, in general, will have fallen and the bonds will not have a selling price that is at least $1,000,000.
One proposed solution is to invest part of the portfolio’s funds in the one-year bonds and the rest in the three-year bonds. How much should be placed in each issue?
Suppose the duration of the three-year security is 2.78 and the duration of the one-year is 1 because it is a discount instrument. We know the proportions (weight) of two debt instruments need to add up to 100% of the portfolio, or converting percentages to decimals, W1 + W3 = 1. We also know that we desire to have a duration of 2 years or (W1)(1) + (W3)(2.78) = 2, where W1 equals the percentage of weight for the one-year duration instrument and W3 equals the percentage weight of the three-year maturity bond with a duration of 2.78. We can use the following equations to solve for the allocation of the two securities to achieve a portfolio that has a two-year duration:
W1 + W3 = 1 (as stated above)
W1 = 1 − W3 (this solves for W1 in terms of W3)
(W1)(1) + (W3)(2.78) = 2 (as stated above)
(1 − W3)(1) + (W3)(2.78) = 2 (substitutes 1 − W3 for W1, allowing us to solve for W3)
1 − W3 + (W3)(2.78) = 2 (multiply (1 -W3)(1) ‘ (1 X 1) and (1 X - W3))
1 + 1.78(W3) = 2 (combines − W3 and 2.78(W3))
1.78(W3) = 1 (subtracts 1 from each side of the equation)
W3 = 1/1.78 (divides 1.78 from each side of the equation)
W3 = 56.18%

W1 = 43.82%

Question 30

Active Bond Portfolio Management

Answer 30

Active management of a bond portfolio is based on the fact that interest rates change, as well as the belief that the bond market is not perfectly efficient. Such management can involve security selection; that is, the portfolio manager tries to identify mispriced bonds. Alternatively, it can involve market timing; the portfolio manager tries to forecast general movements in interest rates. It is also possible for an active portfolio manager to be involved in both security selection and market timing. Although there are many methods of actively managing a bond portfolio, the manager is generally looking for opportunities created by imbalances between interest rate and price movements in order to lock into some profit before the advantage disappears.

Some active bond portfolio management methods include:

contingent immunization
swaps
caps
floors, and
collars.

Question 31

Contingent Immunization

Answer 31

One method of bond portfolio management that has both passive and active elements is contingent immunization. In the simplest form of contingent immunization, the portfolio will be actively managed as long as favorable results are obtained. However, if unfavorable results occur, then the portfolio will be immunized immediately.

This means, in practice, that as long as the portfolio is tracking above a specific need, the portfolio will be active. Given this strategy assumes there is a future liability, if the portfolio were to be valued near or below the liability, the portfolio would be immunized.

This allows for potential upside participation with a rule in place to ensure the liability is met.

Question 32

Bond Swaps

Answer 32

Given a set of predictions about future bond yields, a portfolio manager can estimate holding-period returns over one or more horizons for one or more bonds. The goal of bond swapping is to actively manage a portfolio by exchanging bonds to take advantage of any superior ability to predict such yields.

In making a swap, the portfolio manager believes that an overpriced bond is being exchanged for an underpriced bond. Some swaps are based on the belief that the market will correct for its mispricing in a short period of time, whereas other types of swaps are based on a belief that corrections either will never take place or will take place, but over a long period of time.

Bond Swap Categories
CATEGORY DESCRIPTION
Substitution swap This swap is an exchange of a bond for a perfect substitute or “twin” bond. The
motivation here is temporary price advantage, presumably resulting from an
imbalance in the relative supply and demand conditions in the marketplace.
Intermarket spread swap This swap involves a more general movement out of one market component and
into another with the intention of exploiting a currently advantageous yield
relationship. The idea here is to benefit from a forecasted changing relationship
between the two market components.
Rate anticipation swap This swap is geared toward profiting from an anticipated movement in overall
market rates.
Pure yield pickup swap This swap is oriented toward yield improvements over the long term, with little
heed being paid to interim price movements in either the respective market
components or the market as a whole.
Note: All bonds “swaps” are taxable events, i.e. a sale and a purchase.